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Commentary: An End Run Around Accounting Reform

April 27, 2003

By David Henry

Those crafty accountants are at it again. They're planning a clever end run around a new rule that would force big banks and finance companies to put $500 billion of assets and liabilities on their books. Enron Corp.'s abuse of its infamous off-balance-sheet entities led to the ruling, but Wall Street isn't terribly eager to comply. That's bad for transparency, bad for investors, and bad for the drive to reform corporate accounting.

The dodge is audacious in its simplicity. There, in paragraph 14 of the 66-page rule laid down by the Financial Accounting Standards Board, the best minds in structured finance believe they've found a loophole through which they can drive a coach and horses. The ploy is a version of an old balance-sheet parking dodge -- shunting the assets of one company onto the books of a third party while essentially keeping control of them.

In the new variant, a bank would shift off-balance-sheet entities holding business loans to a private company that would need to own as little as 0.1% of the assets involved. That's far less than the 3% ownership required under the old standard that Enron and others exploited with gusto. FASB now says the company exposed to the brunt of any losses should book the assets. That means the lower the estimates of potential losses, the easier it is to switch the assets to third parties.

The off-balance-sheet entities in question bear little resemblance to the ones that got Enron in trouble. They are used to sell commercial paper and have no significant history of malfeasance -- or big losses. In the 1990s, they became an important source of cheap finance. The likes of Citigroup (C), Bank One (ONE), Bank of America (BAC), and General Electric Capital use them to raise money for clients to borrow at short-term rates without having to count the lending on their own balance sheets -- thereby eating up the capital that regulators normally require banks to maintain against loans they make.

The financial companies argue that if they're forced to put the loans on their books, they face nasty consequences. They'll have to shut down the entities, cut back on lending, or raise the prices they charge borrowers. "If everybody has to consolidate, it would have a serious effect on short-term liquidity in the American capital markets," warns Jason H.P. Kravitt, a structured-finance lawyer for big banks and a partner at Mayer, Brown, Rowe & Maw. State Street Corp. (STT) warned in its annual report that it will cut back on lending if it has to consolidate on its balance sheet the $10 billion of these entities that it administers.

Wall Streeters resent suffering what they see as collateral damage from the attack on Enron. "It is akin to putting tracking devices on every car in the U.S. because a bank robber used a car to get away," says Thomas A. Fritz, a managing director at Standard & Poor's. "It creates an economic problem that was never thought about by those who considered the rules."

The regulators who drew up the rule beg to differ. "That's ridiculous," says Sheryl Thompson, a spokeswoman for FASB, which has set a third-quarter deadline for compliance. "What we're really after here is better accounting."

Still, the 0.1% ploy, advocated by Richard D. Levinson, co-founder of the structured-finance boutique Penstock Partners, could well be the magic bullet for the banks. Ron Lott, FASB's project director on the new standard, ruefully concedes that the "technique, I think, works. [But] it doesn't seem quite right."

He's correct. The banks' case has some merit: No one's interest is served by gumming up the commercial paper market, raising the cost of capital, or damaging banks' ability to serve their clients. But that's no reason to make a mockery of reform.

A better answer would be to put the assets on balance sheets and get bank regulators to ease up on the capital-adequacy rules instead. To treat FASB's effort as a mere hurdle to be jumped is to risk falling into the same trap that led to the whole mess in the first place -- a blatant disregard of sound accounting principles. Nobody promised reform would be easy to live with. But balance-sheet clarity and investor confidence are worth the effort. Henry covers accounting issues.